Top Stories | Sat, 30 Nov 2024 12:02 PM

Top 20 Investment Banking Questions and answers on LBO Model

Posted by : SHALINI SHARMA

1.Walk me through a basic LBOmodel.

An LBO model involves thefollowing steps:

 

1.Make Assumptions: Begin bymaking assumptions about the purchase price, the debt-to-equity ratio, interestrates on the debt, and other transaction details. Operational assumptions likerevenue growth and margin projections may also be included, depending onavailable information.

 

2.Sources & Uses: Create a"Sources & Uses" table to demonstrate how the transaction will befinanced and where the funds will be allocated. This step also calculates theamount of investor equity required.

 

3.Adjust the Balance Sheet:Adjust the company's balance sheet to reflect the new capital structure (debtand equity) and account for Goodwill and Intangibles to balance the Assets andLiabilities sides.

 

4.Financial Projections: Projectcompany financial statements- Income Statement, Balance Sheet, and Cash FlowStatement-to assess the company's ability to pay back its debt. This wouldentail tracking the cash flows and required interest payments every year.

 

5.Exit Assumptions & Returns:Estimate exit value via EBITDA multiple after a specified period and use equityvalue at exit in determining IRR.

 

2. Why leverage an LBO?

Using the tool of leverage, thecompany raises returns on the investment made in the private equity firm'scapital. Debt would therefore reduce the amount of equity that needs to bebrought in at the primary levels so that it is much easier to raise returns onsuch investment. For example, instead of financing a $5 billion acquisitionwith $3 billion in equity and $2 billion in debt, $3 billion in debt mayfinance it and $2 billion in equity. Moreover, by using leverage, thecorporation saves capital to invest elsewhere.

 

3. What are the variables thataffect an LBO model the most?

Critical factors that affect anLBO model are the following:

 

Purchase and Exit Multiples:These have the greatest effect on IRR and returns.

Leverage Levels: The quantum ofdebt impacts returns as well as financial risk

Operational Performance: Growthin revenues and EBITDA margins impact cash flows and ability to service thedebt.

4. How are purchase and exitmultiples determined in an LBO model?

Purchase and exit multiples aregenerally driven by:

Comparable company analysis andprecedent transactions.

A sensitivity analysis showing arange of possible multiples.

In certain instances, a specificIRR target may determine the purchase price, primarily for valuation purposes.

5. What makes an"ideal" LBO candidate?

Ideal LBO candidates exhibitthese characteristics:

Stable, predictable cash flows:Critical to debt repayment

Low-risk business: Reducesuncertainty.

Limited capital expenditurerequirements: Which means cash outflows decline.

Margin expansion potential: Bycost optimization.

Strong Management Team:Operational success crucial.

Collateral base: Debt financingsecurity.

6. How does an LBO model valuea company, and why is it termed as the "floor valuation"?

An LBO model can value a companyby setting a target IRR (e.g., 25%) and then backcalculating the maximumpurchase price a PE firm could pay to achieve that return. It's termed a"floor valuation" because private equity firms typically pay lessthan strategic buyers, who can justify higher valuations due to potentialsynergies.

 

7. Example of a real-life LBO.

Buying a house with a mortgage isa relatable LBO analogy:

 

Down Payment: Like investorequity.

Mortgage: Consists of the debt ofLBO

Mortgage Interest Payments: Likepayments towards interest for debt.

Mortgage Repayment: Similar torepayment towards the principal of the debt.

House Sale: Just like sale of thefirm or issuing an IPO

8. Balance Sheet in an LBOModel Adjustment

An LBO will adjust a balancesheet to have;

Liabilities & Equity Side:

Add on fresh debt

Replace shareholders equity withthat of the contribution of private equity firm.

Assets Side:

Adjust the cash, for transactionfunding.

Use Goodwill and Intangibles as a"plug" to balance the new liabilities.

Other possible adjustments areadding capitalized financing fees to assets.

 

9. Why are Goodwill &Intangibles created in an LBO?

Goodwill and Intangibles are thepremium paid over the company's book value. In an LBO, these items are a"plug" to balance the Assets and Liabilities sides after the equityand debt adjustments.

 

10. Why would a PE firmutilize debt in an LBO rather than cash?

Why the preference for debt in anLBO:

Short investment horizon. For aPE firm, typically seeking an exit within a few years, returns over the cost ofcapital take precedence.

Risk Transfer: In LBO, theacquired company takes the debt burden, thereby transferring much directfinancial risk from the PE firm. Strategic buyers have all the debt themselves,making their leverage even riskier.

11. Do you have to project allthree financial statements in an LBO model? Are there shortcuts?

You don't always need to projectall three financial statements in detail.

 

For instance, you don't need afull Balance Sheet. You can assume the net change in working capital withoutbreaking it out into each component. You do need:

 

An Income Statement to trackprofitability.

A streamlined Cash Flow Statementto determine cash available for debt repayment.

A method to track changes in thedebt balances.

This method does not take muchtime without compromising the key outputs.

12. How do you determine howmuch debt can be raised in an LBO and how many tranches there will be?

Debit levels and structure aregenerally comparable LBO transactions. You are reviewing comparable-sized andindustry companies to understand the debt capacity and the number of tranchestypically used.

 

Key factors are:

 

Recent terms and structures inthe market.

Comparable leverage ratios anddebt types in comparable deals.

13. How do you determine theleverage and coverage ratios appropriate for a company in an LBO?

Leverage and coverage ratios arecompany, industry, and transaction-specific; precedents are set based onsimilar transactions.

 

In order to establish reasonablelevels of leverage and coverage:

 

Assess "debt comps"from recent transactions the same industry and size

Consider the industry normswhereby leverage rarely exceeds 5-10x EBITDA even at the height of the market

14. What is the distinctionbetween bank debt and high-yield debt?

There are two primary forms ofLBO debt, and they each differ significantly:

 

Interest Rates: High-yield debthas fixed interest rates that are higher, but bank debt has lower, floatingrates that are tied to benchmarks, such as LIBOR or the Federal Funds Rate.

Covenants:

High-yield debt has incurrencecovenants, that limit certain actions, such as selling assets or making majorinvestments.

Bank debt is tied to maintenancecovenants, which require that the company meet certain performance metrics,such as not exceeding a certain Debt/EBITDA ratio.

Cost: Bank debt is cheaper butoperationally more demanding.

Large LBOs usually have bothtypes of debt.

 

15. Why might a PE firm preferbank debt in an LBO?

Bank debt may be preferred when:

 

The firm wants lower interestcosts.

There is a need for operationalflexibility, such as large capital expenditures or expansion plans.

16. Why might a PE firm choosehigh-yield debt instead?

High-yield debt may be used when:

 

The firm prefers higher leverageand can tolerate higher interest costs.

There are no plans forsubstantial expansion or asset sales, which reduces the restrictions placed byincurrence covenants.

The company will refinance thedebt or exit the investment reasonably soon.

 

17. Why would a PE firm investin a company in a risky industry like technology?

Although more risks are involved,every industry has companies that are stable in cash flows and have matureoperations. Private equity firms may also specialize in:

 

Industry Consolidation: Buyingand merging competitors to achieve efficiency and market share.

Turnarounds: Reengineeringunderperforming companies to regain profitability.

Divestitures: Spinning offdivisions to create standalone businesses.

These strategies reduce riskwhile attaining desired returns.

 

18. How can a private equityfirm enhance returns in an LBO?

To enhance returns, a PE firmcan:

 

Reduce the Purchase Price:Negotiate better acquisition terms.

Increase the Exit Multiple orPrice: Sell at a higher valuation.

Raise Leverage: Increase theamount of debt financing to decrease equity invested.

Drive Growth: Speed up revenuethrough organic initiatives or acquisitions.

Improve Margins: Cut cost oroptimize operations.

These all theoretically work, butin reality, it is not that easy to execute.

19. What is the "taxshield" in an LBO?

The tax shield refers to the taxsavings arising from the deduction of interest expense on debt. This willreduce taxable income and cash flow.

 

Even though this means taxsavings, total cash flow is less than it would be for a debt-free company sincethere's the expense of interest.

 

20. What is a dividendrecapitalization, or a dividend recap?

A dividend recap occurs when acompany incurs more debt in order to provide a one-time dividend payout toprivate equity investors.

 

This is like asking a friend totake out a loan and give you cash from the loan proceeds. While oftencriticized, dividend recaps are still commonly used in private equity.